October 13, 2008

The modern corporation is used to evaluating performance: employee performance, business unit performance, and, if the company is worth its salt, customer performance. But it’s rare for those in charge of the kit and caboodle to be evaluated themselves: at the turn of the century, only one listed US company in five regularly evaluated its board of directors.

Now, as noted earlier, directors enjoy wide protection from scrutiny – not just from others, but from themselves: a director’s chair comes with a brass nameplate, but rarely a silver mirror. Boards have been reluctant to evaluate themselves for many reasons – some lack the time, some find it more confrontational than clubby, and some simply don’t know how – but this needs to change. The NYSE’s Rule 303A(9)now requires boards to conduct a self-evaluation at least once a year. So how can a board best evaluate itself – and what should it look out for?

The key question the board must ask itself is, “How well did we perform our duty as a board?” That question points to the two kinds of inquiry it must make: into how well it performed – that is, into how well its own processes functioned – and into how effective it was in fulfilling its duties. The board should start with the second question, asking itself “What did we aim to do this year?” If the company’s governance is good, the answers to this question will be in the company charter, and will include developing long-range strategy, holding management to account for agreed performance goals, approving financial reporting, and so on. The next question must be, “Did we achieve each of our aims effectively?” This should be more than just a tick-and-cross exercise. If the board achieved a goal, it should ask, “Why? What worked well?” This will be useful data for compiling a list of best practices. If a goal was not achieved, or not achieved easily, the board must ask why not. Once it has gone through its performance by goal and collected a list of best practices and concerns, it should take one step back and look at its processes. Which worked well? Which need improvement? In a final step, the board should incorporate its findings into its governance process for the following financial year.

Evaluation should be tied into the board’s annual operating schedule, with annual objectives set at the beginning of the financial year, data collected during the third quarter (once it’s becoming clear whether the board’s expectations of management performance are aligned for the year) and a review session at the end of the year.

October 8, 2008

Shrinking back from the legal liability taking up a directorship will involve? Relax. Courts in English-speaking countries have repeatedly refused to look at decisions taken by directors when exercising business judgment. The High Court of Australia put it nicely forty years ago in Harlowes Nominees Pty Ltd. v Woodside:

Directors … may be concerned with a wide range of practical considerations, their judgment, if exercised in good faith and not for irrelevant purposes, is not open to review in the courts.

In other words, creditors and shareholders looking to recover from directors for losses resulting from poor business decisions will be disappointed to know that those decisions are not subject to review by the courts. It’s a massive exemption from liability, and it’s not one enjoyed by doctors, dentists or – until relatively recently, in most Commonwealth countries – even lawyers themselves. So why grant directors such freedom to mess up?

Delve deeply enough into the literature, and you’ll find as many justifications for the rule as you care to name. But there are three central reasons. First, scholars argue that people otherwise qualified to serve as directors won’t do so if their decisions are constantly second-guessed. This is well and good – no one likes to be constantly second-guessed, after all – but it’s not a reason to exempt a person from legal liability. Remember that we’re all responsible for reasonably foreseeable harm caused to others as we go about our daily business. Why should directors – who owe shareholders a fiduciary responsibility beyond what we owe each other in everyday social interaction – be held to a lesser standard than the rest of us?

Secondly, it’s said that courts are not equipped by nature to examine business decisions, and couldn’t act in real time even if they were. But, while it’s true that judges aren’t businesspeople, they’re not architects or forensic psychiatrists, either. That’s why courts call expert witnesses. There’s no reason experienced directors couldn’t be called on to testify about the wisdom of business decisions. And, true, the wheels of justice grind slowly – much more slowly than the wheels of commerce. But most allegations of director misconduct are made after the fact, in the context of an action for damages in the aftermath of bankruptcy, where time is no longer an issue. The courts have mechanisms for acting swiftly – injunctions are frequently granted under urgency – and there’s no reason they couldn’t deliver emergency interim relief in the same way.

The third and final reason given for the business judgment rule is that business requires risk-taking, sometimes even to the point of speculation, and that the directors are free to do just that. The argument here isn’t that, being in a position of responsibility, they should be held to a stricter standard than the rest of us; rather, it’s the reverse. Are the directors spending shareholders’ money irresponsibly on too risky ventures? Then, on this view, it’s up to the shareholders to fire them. Have the directors overcommitted themselves (without going as far as trading recklessly)? Caveat supplier – the firm’s trading partners should have done their due diligence before going into business with them.

Who watches the watchers? The business judgment rule says no one does, as long as the directors are using their powers for proper purposes to make good faith decisions. Why? Logically, the only reason is risk: it’s necessary for business, and someone – in this case, the directors – is allowed to take a lot of it.